IAFE/SunGard 2007 Financial Engineer of the Year Award Dinner

Jack Treynor on Financial Engineering

By Nina Mehta

Jack Treynor, winner of the 2007 IAFE/SunGard Financial Engineer of the Year award, is a legendary figure in finance. He was one of the developers of the Capital Asset Pricing Model in the early 1960s. A pioneer and maverick thinker at every turn, he applied rigor, early on, to a range of fields: his research helped to establish portfolio measurement. In the late 1950s and early 1960s, Treynor worked at Arthur D. Little. Subsequently, at Merrill Lynch, he founded Wall Street’s first quantitative research group.

From 1969 until 1981, Treynor served as editor of the Financial Analysts Journal and is currently on the advisory board of the FAJ and the Journal of Investment Management. A graduate of Haverford College and Harvard Business School, Treynor has published more than 70 papers over the last 40 years. Treynor received the CFA Institute Award for Professional Excellence last year. He is a distinguished fellow of the Institute for Quantitative Research in Finance and has been president, since 1985, of Treynor Capital Management.

IAFE: What does it mean to you to get this award from the International Association of Financial Engineers?

JT: This is a very special group of people. As I see them, they stand in the same relation to the social sciences, particularly economics, as Francis Bacon’s Royal Society did to the physical sciences in the 17th century.

The work of science is done by two kinds of people: learning machines and thinking machines. Learning machines are very important. Without learning machines, all the great, exciting, important insights in science would get lost. But the exciting ideas are discovered by the thinking machines. The intellectual values of learning machines and thinking machines are very different. Thinking machines’ principal concern is failing to challenge an idea that’s false. But learning machines’ principal concern is rejecting as false an idea that’s actually true. With this radical difference in values, these two groups of people aren’t going to be very comfortable with each other.

What happened in the physical sciences was that by the beginning of the 17th century the learning machines had driven the thinking machines out of academe. The result was that the physical sciences weren’t moving forward. Academics had their theories, but they didn’t work very well. The historical importance of the Royal Society is easy to demonstrate: Without it, the Industrial Revolution couldn’t have happened. The physical sciences have never forgotten the Royal Society and Francis Bacon’s lesson. But the social sciences are too young to remember.

IAFE: Are there fewer new ideas in financial engineering now than there were three or four decades ago?

JT: People are ready to challenge the old ideas and move on. The problem with academe and the social sciences today is the problem with the physical sciences in 1610. There is a failure of social scientists, and economists in particular, to generate the new ideas.

The monetarists and Keynesians and neo-Keynesians are just as far apart as ever. They aren’t learning anything from each other. Most of the world’s big social problems are symptoms of failed social science. But the financial engineers are aware of the problem.

IAFE: There are many people delighted you’re getting the IAFE award and some of the recognition they say you have long deserved. When your name comes up in conversation, you seem to be regarded not only with great respect but with tremendous affection by people who don’t know you personally. Why do you think that’s so?

JT: The view you offer is very charitable. I never got a doctor’s degree. When I left MIT [after a year of graduate study in economics at the invitation of Franco Modigliani], one of the professors came up to me and said, “One of these days you’re going to be very sorry you didn’t stay here and earn a doctor’s degree.”

I’ve thought about his comment many times. Instead of staying at MIT, I went back to the Operations Research group at what used to be Arthur D. Little Inc. I’ve been slow to realize that operations research is not merely the application of the techniques of the physical sciences to social problems, but the application of the philosophy of the physical sciences to social problems. It’s no accident that Harry Markowitz and Bill Sharpe worked in operations research early in their careers. Maybe I was lucky that I didn’t continue in the culture of the social sciences.

IAFE: What idea of yours has not received the attention you’d hoped for?

JT: There’s not much interest in my theory of inflation. It’s a very simple theory that any thoughtful, educated person can understand.

IAFE: Just how simple is it?

JT: Inflation is caused by a shortage of machines, not ashortage of workers. When you look back at the history of inflation in countries like the U.S., and you try to understand what happened over the course of business cycles, these two shortages are totally confounded. They get more scarce together, and they get less scarce together. It’s hard to tell which scarcity really drives inflation.

Unfortunately, if your country has a shrinking workforce, and you’re the central banker, it’s critical to know which scarcity matters. If you think the shortage of workers causes inflation, you’ll assume your problem is rising inflation rates and tighten supply. But a shrinking work force will retire your country’s oldest, least-efficient machines. If you think inflation is caused by a shortage of machines, you’ll expect rising real wages and falling inflation.

Japan was the first country to expect a shrinking workforce. Assuming inflation was caused by the scarcity of labor rather than machines, the central bank raised the overnight bank rate 400 basis points. They kept it up there so long, it almost sank the rising sun.

Although they agree that the Phillips Curve, published in 1958, doesn’t work very well, central bankers keep using it. Fifty years is too long for a theory that doesn’t work very well. The late professor Merton Miller said about the Phillips Curve that “It’s just an empirical regularity.”—i.e., Professor A.W. Philips didn’t really understand why it works. Treynor, who, in addition to being not nearly as bright as Merton Miller, is not nearly as nice a person, would have said that Phillips was data snooping.

Now, almost without exception, the major countries in the European Union have fertility rates below the replacement rate. But they haven’t learned the lesson of Japan. There isn’t a single central banker in Europe or Washington, D.C., who says, “We’re not going to make Japan’s mistake.” So I’m worried.

IAFE: What have you been most wrong about?

JT: That’s a tough question because I have made so many mistakes. For example I used to be very enthusiastic about the idea of market efficiency. One of the problems with thinking that way relates to money. What I failed to see was that money derives its special role from the “used car” problem. In our dealings with each other, we have to worry about adversarial transactions motives. But if we had to worry about such motives in our transactions with money, we’d probably go back to barter.

In a world of efficient markets, where we all have the same information, adversarial motives disappear and, with it, the special quality that distinguishes money from used cars. But then the quantity of money and related concepts like the velocity of money cease to matter. For a long time, I failed to grasp this.

IAFE: How would you describe what a financial engineer does?

JT: To me a financial engineer is someone who in his day-to-day work is solving problems that bring him face to face with the inadequacies of theory. Now, with the current terrorism, war and revolutions, we’re waiting for a giant leap forward in our understanding of the social sciences. It isn’t happening. Academics are so proud of their erudition that they can’t even consider a new idea. But financial engineers are tough-minded and inquisitive. Because the financial engineers are thinking machines, they can create a new Royal Society.

Nina Mehta is a senior editor at Traders Magazine. She has written about financial engineering for the last decade and has conducted Q&As with many IAFE award winners.